Alan Miller calls it a scandal. Richard Saunders says it is a technical argument. Either way, disputes over the best way to disclose the costs incurred by investors in mutual funds are not going away any time soon.

Saunders (left) and Miller

Miller and Saunders had a heated debate on the pages of the comment section of Financial News in April. To cut through the arguments, Financial News invited both men to debate the issue face-to-face earlier this month on the neutral ground of the City of London Club, with FN’s Mike Foster and Gren Manuel acting as referees and enforcing Queensbury rules.

Saunders is former chief executive of the Investment Management Association, the trade body whose members now manage more than £4.5 trillion of assets, although he was at pains to point out he no longer speaks for them. He is currently a non-executive director at Investec Asset Management.

Miller has a long history in fund management, including six years as chief investment officer at New Star Asset Management, and before that at Jupiter Asset Management and Gartmore. Miller is now chief investment officer at SCM Private and doubles up as a co-founder of the True & Fair Campaign for cost disclosure. By campaigning against high fees, Miller draws attention to SCM’s relatively low cost of trading its exchange-traded funds portfolios.

The core of their argument is about the total expense ratio, or TER, a figure funds are required to reveal but which covers only their fees and administration costs. It doesn’t include one of the biggest costs of running a fund – commissions on trading the portfolio.

In the debate, Miller said investors needed to be told the costs they will be paying before they buy a fund, after totting up adviser, manager, administration and explicit trading costs. He said: “It is about honesty and ethics. If you buy a car, you are allowed to know the price of the car – even a second-hand car dealer will tell you the price before you buy.”

Saunders said that, while at the IMA, his research team compared the net performance of a sample of mutual funds against benchmarks and found the difference was less than the average TER. He said: “This suggests very strongly there is no systematic consumer detriment.”

There are differences between the two. Miller says investors should know the cost of performance fees and explicit trading costs, while Saunders does not see this as practical. Miller argues European legislation will impose aggregated costs by 2016. Saunders is not convinced this can be achieved.

However, the debate threw up a surprising level of agreement. Both men agreed, for example, that adviser fees should be disclosed by advisers or investment platforms. They also agreed that regulators should act to impose cost disclosure standards on the industry.

Which is probably fair enough.

• ROUND ONE: Measuring costs

Richard Saunders: Ultimately, what matters to investors is what they are going to get at the end of the day. The first thing to say about trading costs is you have to incur them in order to access the return from the markets.

The second thing I would say is that there are some disciplines on fund managers, there are regulatory rules. You have to get the best deal for your clients.

There is an alternative way of looking at this, which is to cut through and say, ‘What is the actual investor experience here?’

A couple of years ago, when I was chief executive of the IMA, I commissioned our statistics team to have a look at this. The results were in a paper which does seem to show that pretty much across the board, the difference between the net return to investors and the performance of the market is less than the average total expense ratio. This suggests very strongly there is no systematic consumer detriment as a result of so-called hidden costs.

Alan Miller: What is the biggest complaint when people talk to their adviser or fund manager, or whoever? It is, nine times out of 10, ‘I don’t understand that, the markets have gone up, but I haven’t made any money. Why is that?’ It is normally part of two reasons, either they bought at the wrong time or they were sold it at the wrong time, or they did not realise what the full costs were.

I was taught a long time ago by [Professor Emeritus at London Business School] Elroy Dimson and he produces a fantastic book called An Investment Yearbook. Within the latest one, he shows a piece of research, this is over a long period of time, 20 years to the end of last year, the annual total shareholder return was 9.3% for the S&P 500 Index. The average actively managed fund was 1% to 1.5% less than that. It is no coincidence that, only this week, professor David Blake [of Cass Business School] looked at a random selection of stocks and funds, over long periods of time, 1998 to 2008, and found that the average active fund underperformed the index by about 1.44% a year. That is almost identical to what was found over 20 years in the States. The figures are consistent.

The return has to be that average minus the costs in aggregate. You need to know how much you are paying upfront. It is about honesty and ethics. If you buy a car, you are allowed to know the price of the car – even a second-hand car dealer will tell you the price before you buy – but the second-hand fund manager, seemingly, cannot do the same.

We hear the response from Yes Minister: ‘I wish it was possible, Prime Minister, but regretfully it can’t be done with 100% accuracy.’ This is the excuse I hear from many types and, if you think about it, which would you rather, would you rather know 50% of the total with 100% accuracy, or 100% of the total with 95% accuracy?

• ROUND TWO: The merits of total expense ratio

Mike Foster: Richard, you were scribbling away furiously there.

Saunders: Yes, there is quite a lot there, obviously. Typical total expense ratios for active equity funds are between 1.5% and 2%. You quoted a figure of 1% to 1.5% as the shortfall compared with market return. But that supports my case: there is no extra drag from transaction costs.

On the layering of distribution charges unbundled by the Retail Distribution Review, I could not agree with you more. When I was at the IMA, I was saying very forcefully to the FSA, as it then was, and I have since said to the FCA, that they really have to get a grip on this, that people are not seeing the total cost of investing and that they need to mandate an obligation on the people nearest to the client – which might be an IFA, it might be a wealth manager, it might be an ‘execution only’ platform – to pull the costs together.

Miller: The European politicians have passed legislation where the different layers are going to have to be added up. You can debate as long as you want but we are not far away from December 2016 and legislation.

Saunders: What I wanted to say on disclosure is that when I was at the IMA, we led in advocating some disclosure around explicit charges and Daniel Godfrey [IMA chief executive] has taken that a step further. I applaud him for that. I think the explicit charges are quite easy to get your hand around, because you can add up the amount of brokerage that is being paid to commissions, you can see the stamp duty bill.

When it comes to the implicit costs, it gets much murkier, firstly, because it is difficult to quantify; secondly, I think there are quite different conceptual issues. For one example, when it comes to the market spread – the difference between what the marketmaker buys a security at and then sells at – all that cost should be loaded on the person buying the security and none of it on the person selling. I have never understood why. Market impact is a difficult thing to get your hands around, because it is a zero-sum gain.

• ROUND THREE: ‘There is no scandal here’

Miller: The key is to do things practically and supply the most information in a readily available format.

Saunders: The key point I wanted to make is that there is no scandal here, that investors are not being systematically misled about what it is costing.

Miller: But why can’t you show it in a place where they see it? You have a calculator, you can add things up, so why not add things up and put it in a place they see?

Saunders: Ultimately, when you look at the net returns, the total expense ratio does seem to give a pretty good idea.

Miller: So if you had the choice of investing in two funds, and both had identical net returns, and one turned its portfolio over 10 times a year and the other once a year, which one would you buy? I think I know which most people’s answer would be.

Saunders: A fund that is turning over 10 times a year and a fund turning over once a year are following different strategies, and the idea that they will be delivering identical returns seems fanciful.

Miller: But it is giving the investor the right to know.

• ROUND FOUR: Incomplete information

Foster: A lot of your argument, Alan, is making transparency more public, like putting it [total expense ratio] on the front of the prospectus?

Miller: Yes, the Oxford English Dictionary definition of ‘hidden’ is ‘out of sight’. And this is key.

Foster: It could be more prominently displayed; I think that is fair to say?

Saunders: I agree. The FCA has now picked up on it and there should be much greater prominence around the total expense ratio rather than the management charge.

Gren Manuel: I think the issue is about transparency: is the consumer better served by a small number of very easy to understand numbers? Or is it better to have huge disclosure for people to pick through on their own?

Miller: Talk about confusing. We have fund charges which do not include initial charges, performance charges or transaction costs. I agree that, in terms of transaction costs, it should just be simply what is practical – taxes, commissions and spreads – because that is a practical way of doing it. You still have to add the other layers, because the consumer needs to have one number, to compare one with another.

Saunders: The TER is a perfectly good indicator of what the investor experience is going to be. On the other things you mentioned, performance fees are virtually unknown in the UK retail market. I don’t understand how you would fold performance fees into a simple disclosure. You could certainly disclose what the basis of performance fees is, as hedge fund managers do, but to fold that into an indicator for investors becomes very complicated, because it is, by definition, dependent on performance. As to initial charges, they are basically disappearing from the market.

• ROUND FIVE: Running out of logic

Miller: On performance fees, back to my point on the fund rather than the average fund, the fact of the matter is, you say they cannot be done, it used to be done, until a year and a half ago it was in the TER.

Saunders: A whole lot goes on, but the practical realities of the world, the way it is, the TER gives investors a good enough indication of what their experience is going to be. If you say they are going to get all these extra charges on top, that is simply, firstly, giving them an unnecessarily gloomy picture of the experience they are going to have and, secondly, putting them off saving.

Miller: It is funny you just said that last point, because of the reasons I have heard from year to year, from different people. And when people run out of logic or sense, two reasons always come up. One is ‘We can’t do it, because it is not going to be 100% accurate’, which is that, basically, you tell a half-truth accurately, rather than a full truth to a greater degree. The other one, which is what you have alluded to, is ‘If people really knew the truth, they would not invest.’ No other industry operates by that standard.

Saunders: I don’t think it is a trivial answer that is difficult to measure, actually. I think it is a perfectly reasonable answer, but also we are in the position where the European regulation mandates the total expense ratio, and the pragmatic evidence of what happens in the real world, rather than in this slightly abstruse discussion about these arcane matters, is that it is a good measure.

Manuel: If you were to say that there needed to be between one and three numbers at the top of the sheet, which investors could understand, what would the numbers be that you would put on there?

Miller: I think the simplest number is the total, so it is the total of fund costs, including transaction costs, including…

Foster: Even including the implicit transaction costs?

Miller: The brokers and the spreads, because you can work out the turnover and multiply by the spreads to get the costs of the spreads quite easily, to add to other layers of costs. If you are buying through an adviser who is charging you upfront, you annualise that over a consistent period and add to the other numbers. So you have, in essence, what used to be called a reduction in yield.

I am a qualified accountant. Accountants have been valuing completely different businesses, showing the profits and losses for years, and there are many, many more moving parts than in the world of investment. And why is it they can come up with common standards, common principles and the investment world can’t?

Saunders: Reduction in yield was a means of combining initial and continuing charges, which ceases to be an issue in a post-RDR world.

Miller: But it included adviser costs and initial platform costs.

Saunders: The big problem is that reduction in yield was based on a full-cost return and investors used to get a misleading picture because they would be given something which assumed that this product they had just bought was going to grow at a steady 10% a year. It was 7%, before it was abolished.

On the other costs, I agree with you, but I don’t think the fund manager is in a position to give them.

Miller: Why doesn’t the person you are buying it from? They know their costs and they go down the chain from beginning to end.

Foster: So the adviser comes up with a document including everything?

Miller: It isn’t hard.

Foster: I think we have slight differences on…?

Miller: The methodology.

Saunders: But the debate gives rise to lurid stuff that gets picked up in some of the press and by the politicians.

Miller: There is an easy solution to that, which is you show it to them and you show it in a place they see it, it is not hard, is it? I have always said one number; we have always said one number from the beginning.

• ROUND SEVEN: ‘Consumers want one number’

Manuel: If Alan came into a position of power, where he could implement his disclosure proposals, do you think that would make a difference to people? Would it put them off investing completely?

Saunders: I doubt that it would make much difference to people’s behaviour, actually. If it is one number, I would opt for the total expense ratio, which is where we are today, for the reasons I have given. If you put a different number there, I doubt it would have much impact on behaviour at all.

Manuel: To me, however, a good analogy is the food industry, where for years the amount of information you used to have to disclose on a packet of cornflakes became longer and longer and longer, and the print became smaller and smaller and smaller, so the manufacturers could say, ‘We disclose everything that goes in our product,’ but nobody could actually read it or understand it. The moment that actually worked was when the government, effectively, mandated down to a very simple scheme on the front, where you say how much salt, how much sugar. The problem with too much disclosure is actually it can serve to confuse.

Miller: We have said, from day one, from day one every year, and we have backed it up by research with consumers, what consumers want is one number and they want it in pounds and pence.

Saunders: You make a good point, Gren. This is exactly what happened in the funds world and in the Ucits IV Directive in 2007. They said, ‘Look, there is a mess of stuff that is out there, that is being given to investors, so we are going to mandate a two-page document,’ it is called the Key Investor Information Document, ‘and we will lay out precisely what must go in that, you cannot deviate from it, anywhere in Europe, as part of the single market in funds, because there is an active single market in funds in Europe,’ and that was precisely what was done.

We have been round that course and there is risk in this. A risk in layering, starting to put more disclosures up there, and the IMA or anybody else cannot depart from that, from what is in that document, although, obviously, firms have more freedom over what they put in factsheets.

• FINAL ROUND: ‘Regulator needs to act’

Miller: The European Parliament has voted through legislation, it is about four lines long, and it is clearly worded, it is the total costs from the underlying investment as to what you receive in one number. It actually says the word “aggregated”, there is not any formal debate.

Saunders: Mifid does not cover the disclosure of Ucits charges. It is different legislation.

Miller: Actually it does, because whoever is selling that fund or investment to the public, they are going to be a Mifid firm, they have to show all the costs, so they have to show their costs and all the other layers down.

The only solution is to have a regulator who forces it upon everyone, because we have seen voluntary codes only operated by those where it is in their personal interest, so they never work, they never get followed by the vast majority or in a proper way.

The only way is for a government and regulators to actually put something sensible, and everybody has to follow it, and then everybody competes to a common standard.

Saunders: I would agree with that.

The transcript of this debate was first published in the print edition of Financial News dated July 7, 2014